Regulatory Reform Is Helping Stocks
The stock market increased yesterday as we are seeing more of the same action we’ve seen ever since Trump was elected. The Dow has had 11 straight record closes. The market remains in an environment of extremely low volatility as the VIX fell 3.07% yesterday. The Dow, S&P 500, and the Nasdaq have not had a 1% move all year. The last time any of them moved 1% was December 7th which is a streak of 53 sessions. It’s important to recognize that while volatility will increase at some point, there is no rule that it must increase right away. It’s easy to look at some of the charts I will show in this article and assume the market is about to crash. Since there are clear reasons why the market is so stable, they will need to change before the market’s dynamics change. Monetary policy is accommodating, fiscal policy is about to become more helpful as corporate tax rates will be lowered, and regulations are being repealed to improve business conditions. This is recipe for stocks to have high multiples.
There has been updated information yesterday on the regulatory front. I consider regulation cuts to be the best way to increase long term productivity growth, so it’s of vital importance. President Trump has promised 75% regulatory cuts. Per The Hill’s analysis he has been delivering on that promise as they have determined there has been a 72% decline in regulatory activity in the first month of Trump’s presidency compared to the final two months of President Obama’s term. Yesterday’s news was that Trump signed an executive order requiring every federal agency to create a regulatory task force to find regulations that should repealed to improve the business environment.
So far, Trump has signed a bill to stop the harmful impacts done to the coal industry by the Stream Protection Rule. The coal industry has been hurt by competition from cheap natural gas and regulations. The second constraint will no longer be a factor. This doesn’t mean there will be a coal renaissance in America, but it does ensure the best product will win which is great for productivity as energy prices will fall. Coal providing more competition with natural gas will lower costs even if coal doesn’t take market share back. Trump has also signed a bill which eliminates energy and mining firms’ reporting requirements which puts American firms on a level playing field with international firms.
As I have said before, the energy sector will receive the most benefits from regulatory cuts. This is something I must keep in mind when I express my bearishness on energy because of the oil correction I am predicting. There is a possibility oil prices can fall, while energy and mining stocks outperform the commodity because their earnings are helped by these regulatory cuts. It’s very important for investors to know where their thesis can go wrong and to avoid having a dogmatic approach to investing.
As I promised, there are some charts which seem to indicate the level of stability and bullishness in the stock market will come to an end quickly. The chart below takes both factors into account as it shows the forward P/E divided by the VIX. The ratio is at a new record high. It’s not surprising to see the ratio this high as the forward PE is above average and the VIX is near record lows. The VIX can stay near record lows for years, so this chart looks more ominous than it is. Also, the VIX can increase to the mid-teens without a market crash. The stock market didn’t even fall 5% as the election neared even though the VIX increased to low 20s. On a bearish note, this chart would be even higher if it looked at the trailing PE which is in bubble territory.
The second bearish chart I have is shown below. It shows the 15-day rolling beta of macro funds. With the Dow hitting 11 straight all-time highs, it’s not surprising to see indicators like this which suggest that the optimism is overstretched. Some hedge funds are nervous, but holding their noses and buying stocks because they can’t afford to sit out of this rally. The squeamish will sell at the first sign of trouble which is why this indicator is bearish. Whenever a trend is going steady for a long time, it encourages momentum traders to join in. They have no confidence in their positions and will sell when the trend turns.
The market is sometimes made to be more complicated than it is. The reality is it is separated into two buckets: risk on and risk off. If you’re bullish and correct, it’s easy to make money and even outperform the indices because you just increase your leverage and the beta of your portfolio. There will always be stocks which go against the grain. An example of this would be a stock that is high beta which doesn’t track the market higher because it has company specific problems. Risk on stocks which have underperformed are Twitter and Chipotle. Most portfolio managers diversify to the point where this isn’t a big enough issue to meaningfully impact performance over the medium term.
Conclusion
I am on the side of the bears who believe that the current high valuations mean aggregate stock returns in the long run will be lower than they have historically been. However, bears need to understand why stocks are expensive to determine when they may fall back down to earth. There is an element of irrational performance chasing in play, but there are other bullish factors which need to be studied. The one which is having a particularly high impact lately is Trump’s regulatory cuts. Sometimes it seems stocks want to fall, like what happened today as they were down almost the whole session. However, investors can’t help but be bullish when they hear a president dedicated to cutting regulations. News about regulatory cuts is in the headlines almost every day. While tax cuts are difficult to pass because the country already is operating at a high deficit, regulatory cuts are much easier to get done and they have a big positive impact on the economy. The White House stated the Obama regulations cost the tax payer $873 billion in total.
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Thanks for sharing